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CHAPTER ONE

AN OVERVIEW OF FINANCIAL INSTITUTIONS

To finance economic activity, money has to flow from those who have excess money (savers) to those who need the money (borrowers). Financial institutions transfer funds between savers and borrowers. Any financial system consists of:

  • Financial institutions, whose main concern is to transfer funds from those with surplus money to those who need the money.
  • Financial markets, where financial claims or financial instruments are bought and sold.

To understand the working of financial institutions, we introduce the concept of surplus and deficit spending units:

SURPLUS AND DEFICIT SPENDING UNITS:

All economic units (e.g. firms, government) can be classified into three groups (sectors, economic agencies):

1-Households (consumers)

2-Business firms (Producers)

3-Government (Public sector)

Each economic unit operate within a budget constraint imposed by its total income for the period. So in any budget period a unit can have:

1-Balance budget (income = expenditure)

2-Surplus budget (income > expenditure)

3-Deficit budget (income < expenditure)

Units with surplus budget are known as surplus spending units (SSUs).

Units with deficit budget are known as deficit spending units (DSUs).

DSUs may include some households, some firms and sometimes the government. But taken as a group firms and government are typically DSUs, while households are typically SSUs.

FINANCIAL CLAIMS

To meet their current expenditure DSUs borrow money from SSUs.

This happens by an SSU lending money to and accepting An IOU from a DSU. An IOU (I owe you): is a written promise to pay a specific amount of money (the principal) plus the interest rate for borrowing money for a given period of time (maturity).

IOUs are known as financial claims. A financial claim is an asset and a liability at the same time.

  • To borrowers (DUSs) financials claim are liabilities.
  • To lender (SSUs) financial claims are assets.

This explains the two faces of debts. A debt is a liability for someone and an asset for someone else. So total financial liabilities outstanding in an economy at a given period should be equal to total financial assets.

Financial claims can be held until maturity or sold before maturity to someone else.

Financial claims differ among themselves according to their:

  • Marketability (the ease by which financial claims can be resold)
  • Maturity (number of periods until maturity)
  • Risk of default (borrower’s failure to make payments as promised)
  • Tax treatment (whether the claim is tax exempt or not)
  • Any special issue feature of the claim.

TRANSFERRING FUNDS FROM SSUs TO DSUs

Transferring funds from SSUs to DSUs can be done by either:

-Direct financing, or

-Indirect financing (intermediation financing)

DIRECT FINANCING

In direct financing, DSUs and SSUs exchange money and financial claims directly. DSUs issue financial claims on themselves and sell to SSUs against money. The exchange of money and financial claims takes place directly between them.

The transactions appear as changes in the balance sheet (assets and liabilities holdings) of the two parties as follow:

------

SSU DSU

------

AssetsLiab.Assets Liab.

------

- Money + Money from - Direct claims

SSU sold to SSUs

+ Direct claims

from DSUs

------

The claims issued by DSU are called direct claims and are typically sold in direct credit markets; such as the money or capital markets. Institutional arrangements to facilitate transfer of funds in direct credit markets include:

  • Private placements: where DSU sells all claims issued to a single institutional investor or a small group of such investors. The main advantages of this method are: the speed by which funds are committed, and the low transactions cost.
  • Brokers: whose main function is to aid in the search process of bringing buyer and seller together. They do not sell and buy financial claims, but provide search information and act as match markers. Their profit comes from commission fees they charge.
  • Dealers: Their primary function is to “make a market” for securities (they are market maker). They sell and buy financial claims. Their profit comes from bid-ask spread (different between the bid and the ask prices) Bid-price: is the highest price offered by the dealer to purchase a given securities. Ask-price: is the lowest price at which the dealer is willing to sell the securities.
  • Investment banks: Help DSUs market newly created (issued) financial claims. Their important function is risk bearing or underwriting. They buy the entire claims at a fixed price and sell it to investments or SSUs. Their profit comes from underwriting spread (difference between fixed and sell price).

Main disadvantages with direct financing:

1-Large denominations: few customers are available.

2-Matchmaking problem: Matchmaking between what an SSU wants to hold and the characteristics of the financial claims issued by DSUs.

To overcome these problems, financial intermediation comes between SSUs and DSUs..

INDIRECT FINANCING (FINANCIAL INTERMEDIATION)

Here financial intermediaries (institutions) purchase direct claims with a given set of characteristics (maturity, interest, denomination, etc) from DSUs, and transform them into indirect claims with different characteristics, which they sell to SSUs.

Different characteristics means, that financial intermediation transform financial claims in way that make them more attractive to the ultimate investor.

This transformation process of direct financial claims into indirect claims is known as financial intermediation. Firms involved in this transformation are known as financial intermediaries.

The balance sheet of the three parties involved will be as follows:

SSU / Financial / Institution /
DSU
Assets / Liabilities / Assets / Liabilities / Assets / Liabilities
- money
+Indirect claims / +Direct claims from DSUs / Indirect claims sold to SSUs / + Money / Direct claims

Note that:

-The balance sheet of financial institution consists entirely of financial claims (direct and indirect).

-A direct claims no longer goes to SSUs and does not appear in their balance sheet.

-Money goes to DSUs from financial institutions who obtain them from SSUs against a transformed claim.

Financial institutions buy financial claims (bonds, government securities, business loans, consumer loans, etc), and sell financial claims like checking accounts, saving accounts, etc.

THE BENEFITS OF FINANCIAL INTERMDIATION:

They enjoy three sources of comparative advantages.

1-They can achieve economics of scale by spreading fixed cost and lower operating cost through specialization.

2-They can reduce transactions costs involved in searching for credit information. (A consumer who wishes to lend directly can also search for information, but usually at a higher cost).

3-They are able to obtain important information about borrowers, and reduce risk of default.

INTERMEDIATION SERVICES:

In producing financial commodities, intermediation perform five basic services:

1-Denomination divisibility: They pool SSU savings and allow those with small saving to participate in large denominations. They are also able to produce denominations with deferent size.

2-Currency transformation: They help to finance international trade. Intermediations do this by buying financial claims denominated in one currency and selling financial claims denominated in other currency.

3-Maturity flexibility: create securities with wide range of maturity, from one day to years.

4-Credit risk diversifications: They are able to spread risk by buying different types of securities.

5-Liquidity: they provide liquidity to customers.

TYPES OF FINANCIAL INTERMEDIARIES:

Financial intermediaries are classified as:

1-Deposit type institutions

2-Contractual savings institutions

3-Investment funds

4-Other type of institutions

1-DEPOSIT-TYPE INSTITUTIONS:

The most commonly recognized intermediaries because most people use their services on a daily basis. They issue checking accounts, saving and time deposits, and they use funds to make loans. They include:

  • Commercial banks: The largest and most diversified, and highly regulated (under control).
  • Thrift institutions: Savings and loans associations and mutual saving banks are commonly called thrift institutions. They issue saving accounts, and use funds for long-term investment to finance mortgage.
  • Credit unions: Credit unions are small non-profit consumer organized and owned. They specialized in consumer loans.

2- CONTRACTUAL SAVING INSTITUTIONS:

They obtain funds on long-term contractual agreements and invest fund in capital markets. They have steady flow of funds through contractual agreements. They are able to invest in long-term securities.

Examples are: Life insurance companies and pension funds.

3- INVESTMENT FUNDS:

These sell shares to investors and use funds to purchase direct financial claims, which are: very liquid and have very short maturity.

Their operation makes easier for small investors to purchase shares in large denominations.

4- OTHER TYPES OF FINANCIAL INTERMEDIATIONS:

There are several types of financial intermediaries that purchase claims securities from DSUs and sell indirect claims to SSUs. These include:

  • Finance companies:

Makes loan to consumers and small business. They include:

-Consumer finance companies

-Business finance company

-Sales finance companies

  • Government agencies:

Government agencies are involved in borrowing and lending activities by selling agency securities and lend funds to certain economic sectors, which they serve.

INTERMEDIATION AND DISINTERMEDIATION

Disintermediation: is the shift of funds that were previously routed through financial institution (intermediation markets) to the direct markets.

If market interest rate is higher than the rate that banks can offer, individuals take their savings from the financial institutions to the direct credit market.

TYPES OF FINANCIAL MARKETS

Financial markets are classified into:

1-Primary and secondary markets

2-Organized exchanges and over-the counter markets

3-Spot, futures, and forward markets

4-Options markets

5-Foreign exchange markets

6-International and domestic markets

1-PRIMARY AND SECONARY MARKETS

A financial claim bought by an investor cold be held up to maturity, or resold before maturity. The initial sale of securities is made in primary markets while the subsequent sale is made in the secondary market.

PRIMARY MARKETS:

Are the markets where financial instruments are sold for the first time to the public (selling claims for the first time).

 Shares sold are either:

-Offering new shares of firms whose shares are already trading in the market place. These issues are called SEASONED ISSUES

-Or new shares (first time issues) of new firms whose shares are not currently trading in the market. These first time issues are called INTIAL PUBLIC OFFERING (IPOs).

Most of the new issues are distributed with the aid of underwriters. The underwriter provides:

  • Origination, which involves the design, planning, and registration of the new shares.
  • Risk bearing, which means the underwriter insures or guarantees the price by purchasing the securities.
  • Distribution, which is the sale of the issue (reselling shares).

SECONDARY MARKETS:

Is where the existing financial claims are resold (selling claims for the second time). Its existence facilitates selling and buying in the primary market. Investors buy new issue on the understanding that they can resell them easily in the secondary markets. Marketability of a security is an important factor that determine its yield.

Dealers and brokers help in the operation of the secondary market.

2-ORGANIZED EXCHANGES AND OVER-THE-COUNTER MARKETS

Financial claims can be traded in organized exchanges or over the counter

ORGANIZED EXCHANGES:

-Organized exchanged like NYSE, provides a physical place and communications facilities for member of the market to conduct their transactions.

-Transactions are conducted under specific rules and regulations.

-Only members of the exchange may use the facilities.

-Only securities listed on the exchange may be traded.

OVER-THE-COUNTER MARKETS (OTC):

-Financial claims are traded by visiting or phoning on OTC dealers or by using a computer system that links OTC dealers.

-There is no central place or location for OTC, and trade takes place in offices or rooms of OTC dealers.

-They have strict rules that must be followed by dealers in the market.

-Dealers "make a market" in securities by quoting a "bid" price at which they are willing to buy the securities and "ask" price at which they are willing to sell the securities. This means that dealer keep inventories of securities and set their bid/ask prices.

-Most transactions are usually arranged by phone, or by using a computer system that links the over-the-country dealers.

-OTC market includes the trading in securities not listed on one of the organized exchange.

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3- SPOT, FUTURE, AND FORWARD MARKETS

SPOT MARKETS: refers to:

-The exchange of securities and other financial claims for immediate payment.

-The term "immediate" can mean a day or a week depending on the settlement procedures in the particular market.

-The spot market is also called the "cash" market.

FUTURE MARKETS:

- These are markets where people trade contracts for future delivery of securities (such as government bonds), cash goods (such as a kilo of gold), or the value of securities.

- The delivery date is the future time when the contract is settled by the exchange of cash for the contacted goods.

- Future contracts are traded in the organized exchanges.

- Contract is standardized in terns of delivery amounts, instruments, and dates.

FORWARD MARKETS: Where

-Contracts for future delivery are negotiated and sold over-the-counter rather than through an organized exchange.

-Delivery dates, amounts, and terms of forward contract are not standardized but are negotiated between the two counterparties (buyer and seller).

4- OPTIONS MARKETS:

- These are markets where options contracts are traded.

- Options contracts are contracts that call for conditional future delivery of a security or a good or a futures contract. They call for one party (the option writer) to perform a specific act if called upon by the option buyer or owner.

- Option contract gives the buyer the right to either buy or sell a security depending upon whether the option is a “call” or “put” option.

- Call options: give the buyer the right to buy a predetermined (given) amount of a security at a given/ agreed price on, or possibly before, the expiry date of the options.

- Put options: give the buyer the right to sell a predetermined (an agreed) amount of a security at the agreed price prior to the option’s expiry date.

- Options contract are traded on organized exchanges.

5-FOREIGN EXCHANGE MARKET

These are markets on which foreign currencies are bought and sold. Foreign currencies such as British£, Japanese ¥, and USD $ are traded against other foreign currencies. Foreign currencies are traded either for spot or forward delivery over the counter at a large commercial banks or investment bank charges. Future contracts for foreign currencies are traded on organized exchanges.

6-INTERNATIONAL AND DOMESTIC MARKET

Financial markets can be classified as either domestic or international markets depending upon where they are located. Among the well known international markets are the Eurodollar and the Eurobond markets.

OPERATIONS OF MAJOR FINANCIAL MARKETS:

Financial markets provide a way in which people can arrange to exchange financial claims for cash or other considerations. They operate by:

  • Determining the price and quantity to be exchanged (either on the floor of an exchange or through a computer network, or over the phone in an OTC market.
  • Following a clearing and settlement procedure to exchange claims for cash according to the rules of each exchange or market.

Pricing mechanism depends on the type of financial markets:

Its varies from:

-A static (fixed) price in the London gold market, to

-A continuous auction market with specialist on exchange, to

-A continuous negotiated price determination on the OTC markets.

OPERATION OF ORGANIZED EXCHANGES:

  • They use specialist system to conduct continuous auction market.
  • Companies get their stocks listed on the exchange, if

1-They meet exchange standards regarding company size, No. of shares of stock securities, No. of stock holders, required information disclosure, and stock voting requirements.

2-They are willing to pay the required annual fees for exchange listing. (Exchange listing is valuable to companies since it provide assurance of liquidity, evaluation of performance, and make company visible to invests)

  • Each stock listing is assigned to a specialist who makes the market for the stock listed. (Using the bid/ask price continuously, he can enter his own orders of buy and sell, to insure that the bid/ask prices are close to each other).
  • He maintains an order book of unfilled orders. This gives him advantage over the participants in the markets, since he can observe (notice) the build up of buy or sell orders.

OPERATION OF OPTIONS MARKET: